CAPITAL BUDGETING
Techniques of Capital Budgeting
1
Introduction




A truck manufacturer is considering investment in a new plant.
An airliner is planning to buy a fleet of jet aircrafts
A commercial bank is thinking of an ambitious computerization
programme
A pharmaceutical firm is evaluating a major R&D programme.
All these are the examples of situations involving capital
expenditure decision.
Essentially each of them represents a scheme for investing
resources which can be analyzed and appraised reasonably
independently.
2
Understanding Capital Expenditure



Also referred to as Capital Investment or Capital Project or
just Project.
The basic characteristic of Capital Expenditure is :
• Typically involves a current outlay (or current and
future outlays) of funds
• In the expectation of a stream of benefits extending far
into the future.
However, from accounting point of view, Capital
Expenditure is the one shown as asset on the Balance Sheet.
This assets, except in the case of non-depreciable asset like
land, is depreciated over its life.
3
Understanding Capital Expenditure



In accounting, the classification of an expenditure as capital
expenditure or revenue expenditure is governed by:
• Certain conventions
• Provisions of law
• Management’s desire to enhance or depress reported
profits.
Outlays on R&D, major advertising campaign,
reconditioning of P&M may be treated as revenue
expenditure for accounting purposes, even though they are
expected to generate a stream of benefits in future.
Therefore, such expenditures qualify for being capital
expenditures as per our definition.
4
Understanding Capital Expenditure

Capital expenditures have three distinctive features:
1. They have long-term consequences
2. They often involve substantial outlays.
3. They may be difficult or expensive to reverse.

How a firm allocates its capital (the capital budgeting
decision) reflects its strategy and business. That’s why the
process of capital budgeting is also referred to as strategic
asset allocation.
Techniques of Capital Budgeting are helpful in identifying
valuable investment opportunities.

5
What is Capital Budgeting?
Capital budgeting refers to the process of deciding how
to allocate the firm’s scarce capital resources (land,
labor, and capital) to its various investment alternatives
 The process of planning for purchases of long-term
assets.


Nature of capital budgeting:
Evaluating and selecting long-term investments in:
• tangible assets
• intangible assets
Designed to carry out an organization’s strategy
6
The Manager
Resource Decisions
Investment Decisions
Operating
Decisions
Human Resources
Decisions
Information
Decisions
Financing Decisions
Managing the Firm’s Resources
Cash Management
Inventory Management
Working Capital Management
Investment in Human Capital
Long-term Assets
Accounts Receivable
Recruitment, Selection
Training, Productivity
Performance Appraisal
Compensation
Unions & Labor Relations
Economics of Information
Database Management
Data Modeling
IS Planning & Development
Debt vs. Equity Financing
Financial Leverage
Dividend Pay-out
Competition,
Life cycle effects,
International events,
etc.
Cash Inflows
& Earnings
Shareholder
Value
Risk-adjusted
Discount Rate
Cost of
Capital
Financial
Markets
7
7
General Steps in Capital Budgeting
1.
2.
3.
4.
5.
6.
7.
8.
Translate strategy to capital needs
Generate alternatives
Project financial results
Perform financial analysis
Assess risks
Consider non-financial factors
Select projects
Post-approval review
8
Capital Budgeting Process
1.
Identification of potential investment opportunities.
(Planning Body)
• Estimate the criteria of target.
• Monitor external environment regularly to scout
investment opportunities.
• Formulate a well defined corporate strategy based on
thorough SWOT analysis
• Share corporate strategy and perspectives with persons
who are involved in the process of capital budgeting.
• Motivate employees to make suggestions.
9
Capital Budgeting Process (contd..)
2.
Assembling of proposed investments.
• Investment proposal identified by the production
department and other departments are submitted in a
standardized capital investment proposal form.
• Routed through several persons before it arrives to
Capital Budgeting Committee.
• Investment proposals are usually classified into various
categories for facilitating decision making:
•
•
•
•
Replacement investment
Expansion investments
New product investments
Obligatory and welfare investments
10
Capital Budgeting Process (contd..)
3.
4.
Decision making.
• A system of rupee gateways usually characterizes capital
investment decision making.
• Executives at various levels are vested with the power to
okay investment proposals up-to certain limits.
• Investment requiring higher outlays need the approval of
the BoD.
Preparation of Capital Budget and appropriations
• The purpose is to check in order to ensure that the fund
position of the firm is satisfactory at the time of
implementation.
• Provides an opportunity to review the project at the time
11
of implementation.
Capital Budgeting Process (contd..)
4.
Implementation
• Translating an investment proposal into a concrete
proposal is complex, time-consuming, and risk-fraught
task.
• For expeditious implementation at a reasonable cost,
the following are helpful:
•
•
•
5.
Adequate formulation of projects – necessary homework and
preliminary studies.
Use of the Principle of Responsibility Accounting
Use of Network Techniques – CPM and PERT
Performance review.
• Post-Completion Audit- provides feedback.
• Comparing actual performance with budgeted ones.
12
Project Classification
1.
2.
3.
4.
5.
6.
Mandatory Investments
Replacement Projects
Expansion Projects
Diversification Projects
R&D Projects
Miscellaneous: Recreational Facilities,
Executive Aircrafts, Landscaping etc.
13
Investment Criteria
Investment Criteria
Discounting Method
Non-Discounting Methods
NPV
Payback Period
Benefit-Cost Ratio
ARR
IRR
Discounted Payback
14
Overview

All of these techniques attempt to compare
the costs and benefits of a project

The over-riding rule of capital budgeting is to
accept all projects for which the cost is less
than, or equal to, the benefit:
• Accept if:Cost  Benefit
• Reject if: Cost > Benefit
15
The Example


We will use the following example to demonstrate
the techniques of capital budgeting
Assume that your company is investigating a new
labor-saving machine that will cost $10,000. The
machine is expected to provide cost savings each
year as shown in the following timeline:
-10,000 2000
0

1
2500
3000
3500
4000
2
3
4
5
If your required return is 12%, should this machine
be purchased?
16
1. The Payback Period Method

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

The payback period measures the time that it takes to
recoup the cost of the investment.
If the cash flows are an annuity, then we can simply
divide the cost by the annual cash flow to determine
the payback period
Otherwise, as in the example, we subtract the cash
flows from the cost until the remainder is zero
The shorter the payback period, the better
Generally, firms will have some maximum allowable
payback period against which all investments are
compared
17
The Payback Period: An Example

For our example project, we will subtract the cash
flows from the initial outlay until the entire cost is
recovered:
10,000

Cumulative Payback
-
2,000
1 year
=
8,000
-
2,500
=
5,500
-
3,000
3 years
=
2,500
3 years < Payback < 4 years
2 years
Since it will take 0.7143 years (= 2500/3500) to
recover the last 2,500, the payback period must be
3.7143 years
18
Computation
Year
Cash Flow
Cumulative Net Cash Flow
0
-10,000
-10,000
1
2,000
-8,000
2
2,500
-5,500
3
3,000
-2,500
4
3,500
1,000
Hence, Payback Period lies between year 3 and 4
19
Evaluation of Payback Period Method






Simple; both in concept and application.
Has only few hidden assumptions.
Rough and Ready method for dealing with risk.
Favors projects which generate substantial cash inflows in
earlier years and discriminates against project which bring
substantial cash inflows in later years but not in earlier
years.
If risk tends to increase with futurity – the payback criterion
may be helpful in weeding out the risky projects.
Since it emphasizes earlier cash inflows, it may be a sensible
criterion when the firm is pressed with the problems of
liquidity.
20
Problems with the Payback Period
It ignores the time value of money
 It ignores all cash flows beyond the payback period
 It is a measure of project’s capital recovery, not
profitability
 Though it measures a project’s liquidity, it doesn’t
indicate the liquidity position of the firm as a
whole, which is more important.
 The cutoff payback period is subjective.

21
Example
Year
Cash flow of A
Cash flow of B
0
(100,000)
(100,000)
1
50,000
20,000
2
30,000
20,000
3
20,000
20,000
4
10,000
40,000
5
10,000
50,000
6
-
60,000
Payback Criterion prefers A with payback period of 3 years
over B with payback period of 4 years.
But B has very substantial cash inflows in the years 5 and 6
22
2. The Discounted Payback Period


The discounted payback period is exactly the same as
the regular payback period, except that we use the
present values of the cash flows in the calculation
Since our required return (WACC) is 12%, the
timeline with the PVs looks like this:
-10,000 1785.71 1992.98 2135.34 2224.31 2269.71
0


1
2
3
4
5
The discounted payback period is 4.82 years
Note that the discounted payback period is always
longer than the regular payback period
23
Computations
Year
Cash Flow
Discounting Present Value Cumulative
factor @ 12 %
net cash flow
0
-10,000
1.000
-10,000
-10,000
1
2,000
0.893
1,786
-8214
2
2,500
0.797
1992.5
-6221.5
3
3,000
0.712
2136
-4085.5
4
3,500
0.636
2226
-1859.5
5
4,000
0.567
2268
408.5
Payback Period = 4.1 years
24
Problems with Discounted Payback



The discounted payback period solves the time value
problem, but it still ignores the cash flows beyond the
payback period
Therefore, you may reject projects that have large
cash flows in the outlying years that make it very
profitable
In other words, any measure of payback can lead to a
focus on short-run profits at the expense of larger
long-term profits
25
3. Accounting Rate of Return (ARR)




Also called Average Rate of Return
Also called Average Accounting Return (AAR)
There are many different definitions of the ARR.
However, in one form or other, ARR is always defined
as
ARR 
Some measure
of average accounting
profit
Some measure
of average accounting
value
• Measure of accounting profit can be PAT or N
• Measure of accounting value is Book Value
26
Example
Suppose we are deciding whether or not to open a
store in a new shopping mall. The required
investment in improvements is $ 500,000. The store
would have a five-year life because everything
reverts to the mall owners after that time. The
required investment would be 100 % depreciated
over five years. So the depreciation would be $
500,000 / 5 = $ 100,000 per year. The tax rate is 25 %.
Table ahead shows the projected revenues and expenses
27
Computation
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
433,333
450,000
266,667
200,000
133,000
Expenses
200,000
150,000
100,000
100,000
100,000
EBDT
233,333
Depreciation
100,000
EBT
133,333
Tax @ 25 %
33,333
NI
100,000
150,000
50,000
0
50,000
28
Solution
A verage NI 
100,000  150,000  50,000  0 - 50,000
 50 , 000
5
Average
BV of Investment

500,000  0
 250 , 000
2
ARR 
50 , 000
 20 %
250 , 000
The project is acceptable if the ARR exceeds the target ARR
29
Evaluation of ARR method
It is simple to calculate
 It is based on accounting information, which
is readily available and familiar to
businessmen.
 While it considers benefits over the entire life
of the project, it can be used even with the
limited data.

30
Problems with ARR method




ARR is not the rate of return in any meaningful economic
sense. It is just the ratio of two accounting numbers, and is
not comparable to the returns actually offered.
It is based upon accounting profit, not cash flow.
It does not take into account the time value of money.
The ARR measure is internally inconsistent. While the
numerator represents profit belonging to equity and
preference stockholders, its denominator represents fixed
investments, which is rarely, if ever, equal to the
contributions of equity and preference stockholders.
31
The Net Present Value

The net present value (NPV) is the difference
between the present value of the cash flows (the
benefit) and the cost of the investment (IO):
N P V  P V C F  IO


In other words, this is the increase in wealth that the
shareholders will receive if the project is accepted
All projects with NPV greater than or equal to zero
should be accepted
32
NPV Decision Rule
Maximize Net Revenues
Does Project Produce
Revenues
(Positive Net Cash
Inflows?)
Yes
Is PV of cash inflows ³
PV of cash outflows?
Project Is
Acceptable
Yes
(Positive NPV)
No
No
Reject Project
Rank Projects Using
Profitability Index
Does Not Satisfy
Hurdle Rate
MINIMIZE COSTS
Net Present Values Will Be
Negative
Project selection is based on
project with LOWEST
absolute value for NPV
Present value of
future cash flows
Investment Cost
=
Profitability
Index
33
The NPV: An Example


NPV is calculated by subtracting the initial outlay
(cost) from the present value of the cash flows
Note that the discount rate is the WACC (12% in this
example)
 2000
2500
3000
3500
4000 

  1 0 0 0 0  4 0 8 .0 6




2
3
4
5 
 1.1 2 1
 1.1 2  1.1 2  1.1 2  1.1 2  



Since the NPV is positive, the project is acceptable
Note that a positive NPV also means that the IRR is
greater than the WACC
34
The Internal Rate of Return



The internal rate of return (IRR) is the discount rate
that equates the present value of the cash flows and
the cost of the investment
Usually, we cannot calculate the IRR directly, instead
we must use a trial and error process
For our example, the IRR is found by solving the
following:
1 0 ,0 0 0 

2000
1  IR R 
1

2500
1  IR R 
2

3000
1  IR R 
3

3500
1  IR R 
4

4000
1  IR R 
5
In this case, the solution is 13.45%
35
IRR Decision Rule
Maximize Net Revenues
Does Project
Produce Revenues?
(Positive Net Cash
Inflows)
Yes
Is IRR ³ Hurdle Rate?
Yes
Project Is
Acceptable
No
No
Reject Project
Capital Rationing
May Use IRRs to
Rank Projects from
Lowest to Highest
MINIMIZE COSTS
Internal Rate of Return will
be Negative or Impossible to
Compute
Project selection is based on
project with LOWEST
absolute value for IRR
OR use NPV technique
36
Problems with the IRR


The IRR is a popular technique primarily because it is
a percentage which is easily compared to the WACC
However, it suffers from a couple of flaws:
• The calculation of the IRR implicitly assumes that the cash
flows are reinvested at the IRR. This may not always be
realistic.
• Percentages can be misleading (would you rather earn 100%
on a $100 investment, or 10% on a $10,000 investment?)
37
The Profitability Index

The profitability index is the same as the NPV, except
that we divide the PVCF by the initial outlay:
PI 
PV CF
IO


Accept all projects with PI greater than or equal to
1.00
For the example, the PI is:
PI 
1 0 , 4 0 8 .0 6
 1.0 4 0 8
1 0 ,0 0 0
38